How Do Real Estate Investment Trusts Grow
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One argument that might be made against real estate investment trusts is that, because they are required by the government to pay out at least 90% of net income to their shareholders, they don't have the cash from retained earnings to expand their businesses.
However, good REIT management teams have found ways to raise the money they need.
REIT Investor Want to See Dividends Go Up Every Year
Sometimes they raise money by selling additional shares of stock, including preferred stock.
They can borrow money from the debt markets through issuing unsecured notes and debentures -- bonds.
They can do private placement offerings.
They can sell poor performing properties and reinvesting the proceeds in more profitable real estate.
Good REIT management also seek ways to raise additional cash from their existing businesses, by raising rents and reducing expenses *this includes reducing overhead.). This increases their Funds From Operations (FFO).
When speaking of this, even non-retail REITs make use of a retail industry term -- same store sales. That is, the more sales that can be generated by the same store, the more profitable it. The more rent and other revenue that can be raised from the same property, the profitable it is and the more cash it generates for the company.
This can include raising rents on existing occupants, upgrading properties to higher-level occupants and reducing vacancy rates. It can include upgrading or expanding the property.
Retail REITs, especially shopping malls, usually have percentage-rent clauses in their leases. This means that the mall gets a percentage of the store's revenue above a certain preset level. The more successful the store, the higher rent it pays. Keep that in mind the next time you hear a commercial for a shopping mall on the radio -- the mall wants you to come and shop there because the more money their individual stores make, the more rent the mall receives.
Some REIT leases include periodic rent bumps that are fixed amounts or based on an index of inflation such as the Consumer Price Index.
Some mall and other types of REITs save on expenses by getting occupants to pay for common needs such as security, advertising, and janitorial services. This is known as expense sharing or cost recovery.
Overall, the more cash the real estate investment REIT can raise through its operations, the higher its internal rate of return or IRR.
Obviously, the Higher a Company's Internal Rate of Return is, the Better for its Investors
Of course, the stronger the real estate trust company is to begin with, the more able it is able to raise additional money.
The REIT Real Estate Investment Trust can use the additional cash to purchase additional properties, or even to purchase entire private real estate companies, or even other REITs.
The goal is to find opportunities to make an additional internal rate of return that's higher than the company's cost of equity capital. The difference between the cost of capital and the FFO a company can earn from the property is called the spread.
Strong Real Estate Investment Trusts have picked up great properties at bargain basement prices following local and national real estate market collapses. Eventually demand picks up again, and the REIT is making money off the properties.
Some REITs are Able to Expand by Developing New Properties in their Specialization and Local Geographic Area
Of course, this depends on their ability to raise the necessary capital to fund the development until it begin making money.
Of course, such development projects come with the risk of cost overruns on the construction, the demand for the space may be reduced during the development period (perhaps a recession has just started), and the risk that interest rates rise during the construction period.
Some real estate companies have formed joint ventures (JVs) with institutions to develop, acquire and manage properties. The REIT provides the skills and experience to acquire, develop and manage the commercial properties. The institutions provide the capital. Both can benefit.
With the passage of the REIT Modernization Act, these trusts have been allowed to engage in real estate-related businesses.
REIT trust investors should look for management teams who are aggressively seeking to increase both Funds From Operations and Internal Rates of Return.
Next: NAREIT -- the REIT industry trade association.
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